Under the hood – Vanguard international index funds in 2017

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Vanguard issues annual reports for the firm’s international and global index funds on October 31 of each year. The reports provide information that can highlight some of the underlying conditions affecting a fund’s future capital gains distribution outlook; an indication of a fund’s foreign tax credit; the level of security lending in each fund, and a means of measuring investor turnover in the funds.

Tax implications

Capital gains

Mutual funds are legally structured as pass-through conduits of investment income. The income usually comes from dividends and interest received from securities or by profits realized by selling securities. By law, the fund must distribute income and gains to shareholders or else pay tax on retained income. Funds cannot, however, pass realized losses on to shareholders. These losses are retained by the fund, and can be used to offset future gains.

Taxable shareholders are no doubt pleased when they open their 2017 annual reports and see that none of the Vanguard international index funds has distributed a capital gain over the past five fiscal years.

While not distributing gains, the funds at times realize net gains during a given fiscal year. Often a fund will offset any realized gains with realized losses, or use retained loss carryovers to offset gains, thus providing shareholders zero capital gains distributions. In 2017,  the  Vanguard Pacific Stock Market Index fund and the Vanguard FTSE All-World ex US Small Cap Index fund both used loss carryovers to offset realized gains.

In addition, Vanguard international index funds contain both mutual fund share classes and exchange-traded fund share classes. The exchange-traded funds frequently realize in-kind redemption gains. Because in-kind redemption gains are not taxed to the fund or its shareholders, the fund manager will usually select shares with the lowest tax basis for redemption baskets.

Although these gains are not taxed, they are nonetheless included in a fund’s reported annual realized gain. Netting out these non-taxable gains produces the actual taxable gain or actual realized loss. The table below shows the 2017 reported gain or loss realized for each Vanguard international fund, the in-kind redemption gain or loss, and the actual net realized gain or loss.

As an accounting entry, in-kind redemption gains become a part of the fund’s paid-in capital.

Fund Gain/Loss In-kind Redemption Net Gain/Loss
Total international (778,404,000) 119,486,000 (897,890,000)
FTSE all world ex US (200,378,000) 0 (200,378,000)
Europe 278,000 21,450,000 (21,172,000)
Pacific 48,849,000 7,905,000 40,944,000
Emerging markets (539,822,000) 0 (539,822,000)
FTSE all world ex US small 57,508,000 32,169,000 25,339,000
Total World 23,538,000 49,101,000 (25,563,000)
Global ex us real estate 49,701,000 30,225,000 19,476,000

More on loss carryovers

As noted, realized losses cannot be distributed to shareholders. Surplus losses can be “carried over” to subsequent years when they can be used to offset future gains. Prior to 2010, these carryover losses where subject to expiration dates.

The passage of the Regulated Investment Company Act Modernization Act of 2010 stipulated that mutual fund losses could be carried over indefinitely, but these losses must be used before taking any expiring loss carry forwards.

The table below shows each fund’s loss carry forward and shows both the amount and percentage of unexpiring carry forwards.

Fund Total Loss Carryforwards 2011 Forward Unexpiring % Unexpiring
Total international 2,260,337,000 2,260,337,000 100.00%
FTSE all world ex US 1,341,435,000 1,229,645,000 91.67%
Europe 542,064,000 92,426,000 17.05%
Pacific 84,127,000 0 0.00%
Emerging markets 8,187,725,000 7,673,917,000 93.72%
FTSE all world ex US small 139,472,000 130,756,000 93.75%
Total World 184,012,000 168,215,000 91.42%
Global ex us real estate 98,031,000 96,083,000 98.01%

The considerable level of unexpiring carryover losses in most of the funds suggests that most, if not all, of the carryover losses with expiration dates will actually expire without being used. As the table below indicates, six of the international funds had carryover losses expire in 2017.

If a carryover loss expires, it becomes a part of the fund’s paid in capital.

Fund 2017 Expired 10/31/2018 Expiring 10/31/2019 Expiring
Total international 463,014,000
FTSE all world ex US 138,342,000 32,560,000 79,230,000
Europe 1,500,333,000 282,885,000 166,753,000
Pacific 607,373,000 29,743,000 54,384,000
Emerging markets 1,591,794,000 212,374,000 301,434,000
FTSE all world ex US small 8,716,000
Total World 777,000 1,086,000 14,711,000
Global ex us real estate 1,948,000

Given that in-kind redemption helps improve a fund’s tax basis, it is somewhat  helpful to examine a fund’s share class distribution. Most Vanguard index funds have mutual fund share classes (investor shares, lower cost admiral shares, and institutional shares) as well as exchange-traded fund shares. The following table shows the ratio of exchange-traded fund share class assets to total fund share class assets. As one can see, exchange-traded shares represent a majority share of most of Vanguard’s international index funds. The lone exception is the Total International Fund, which has a history dating back to 1994, but only added exchange-traded shares in 2011. In addition, mutual fund shares of the Total International Fund are used in Vanguard ‘s suites of  balanced target date and target risk funds.; the positive investor inflows into these funds  assures a large issuance of Total International mutual fund shares.

Fund Total Assets ETF Assets ETF/Total Assets
Total international 315,634,959,000 9,669,881,000 3.06%
FTSE all world ex US 35,840,868,000 21,639,662,000 60.38%
Europe 24,211,881,000 17,879,584,000 73.85%
Pacific 8,107,743,000 5,015,402,000 61.86%
Emerging markets 88,926,554,000 64,966,611,000 73.06%
FTSE all world ex US small 5,605,896,000 4,568,035,000 81.49%
Total World 13,806,000,000 9,755,332,000 70.66%
Global ex us real estate 5,785,758,000 5,121,577,000 88.52%

Foreign tax credit

The annual report reveals the amount of foreign tax a fund has paid during the fiscal year. The foreign tax paid on the fund’s dividend income can qualify for a foreign tax credit on a taxable investor’s tax return. Dividing the foreign tax by a fund’s average net assets provides a percentage estimate of the value of the credit.

Fund Average Net Assets Foreign Tax Paid
Foreign Tax Credit
Total international 268,472,804,000 623,021,000 0.23%
FTSE all world ex US 29,797,396,000 67,168,000 0.23%
Europe 19,157,011,000 38,308,000 0.20%
Pacific 6,664,692,000 11,736,000 0.18%
Emerging markets 73,475,686,000 214,389,000 0.29%
FTSE all world ex US small 4,291,769,000 8,919,000 0.21%
Total World 11,191,845,000 12,102,000 0.11%
Global ex us real estate 4,701,194,000 12,536,000 0.27%

Security lending

Vanguard international stock index funds  earn additional income by lending securities to qualified institutional borrowers. The firm allocates 100% of after expense  security lending earnings to the fund.

A fund’s expenses are paid out of fund earnings. Given that the US tax code gives a tax preference to dividends that qualify for lower tax rates, it is prudent for fund managers to allocate non-qualified income to fund expenses. The table below shows the amount of security lending income earned by each fund in fiscal year 2017 and calculates its percentage ratio to total annual fund expenses.

Fund Net Security Lending Income Total Expenses % of Expenses
Total international 202,547,000 319,489,000 63.40%
FTSE all world ex US 15,140,000 32,156,000 47.08%
Europe 13,686,000 19,779,000 69.19%
Pacific 5,406,000 7,092,000 76.23%
Emerging markets 32,189,000 102,786,000 31.32%
FTSE all ex US small 11,882,000 6,340,000 187.41%
Total World 3,961,000 12,185,000 32.51%
Global ex us real estate 4,578,000 6,638,000 68.97%

 Turnover

The annual report documents the rate of annual turnover of its assets by the fund manager. In addition, the reports also document the sales and redemption of fund shares by shareholders. This data allows us to compute a redemption-to-average net assets ratio (R/ANA) that corresponds to a shareholder annual turnover rate. The following table reports the investor sales and redemption in each fund using a composite total of all share classes.

Fund Average Net Assets Sales Redemptions
Total international 268,472,804,000 65,457,171,000 31,907,347,000
FTSE all world ex US 29,797,396,000 7,595,777,000 2,425,323,000
Europe 19,157,011,000 6,414,373,000 1,724,208,000
Pacific 6,664,692,000 1,579,455,000 488,440,000
Emerging markets 73,475,686,000 17,001,007,000 2,212,648,000
FTSE all world ex US small 4,291,769,000 1,639,162,000 230,272,000
Total World 11,191,845,000 4,047,113,000 1,229,645,000
Global ex us real estate 4,701,194,000 1,736,357,000 715,911,000

The table below provides ratio data for each fund. The turnover percentage documents the fund manager turnover of assets. The R/ANA ratio documents the shareholder turnover of assets. The redemption-to-sales ratio ( R/S ) shows net shareholder purchase or net shareholder redemption in a fund. A ratio less than one shows net purchase; a ratio greater than one shows net redemption.

The R/ANA and R/S ratios, viewed together, can signal market timing activity within a fund. For example a fund showing an R/ANA ratio of 400% and an R/S ratio of 1 (equal buys and sells) is likely being market timed by fund shareholders.

Fund Turnover R/ANA R/S
Total international 3% 12% 0.49
FTSE all world ex US 4% 8% 0.32
Europe 4% 9% 0.27
Pacific 3% 7% 0.31
Emerging markets 6% 3% 0.13
FTSE all world ex US small 14% 5% 0.14
Total World 10% 11% 0.30
Global ex us real estate 6% 15% 0.41

Notes

  • Table data is derived from fund annual reports. Average net asset data is derived from NSAR reports on EDGAR. The computations are derived from  this google spreadsheet.
  • The Vanguard Developed Market Index Fund has a fiscal year ending December 31. The annual report is not issued along with Vanguard’s international and global stock funds examined in this report.

 

About

Barry Barnitz, administrator of both the Bogleheads® wiki and of Financial Page, a Bogleheads® blog. In addition I serve as an administrator of finiki, the Canadian financial wiki, and as an administrator of the John C. Bogle Center for Financial Literacy site.

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